Scared of stocks? Bonds have risks, too

With many investors disenchanted or outright frightened by stock market returns since early 2000, bonds are back in vogue. Yet many investors don't understand the basics, let alone the subtleties, of bonds, says Dennis Filangeri, a certified financial planner based in San Diego.

For example, a recent survey by American Century Investments found that only 1 in 200 respondents could correctly answer 10 basic questions about bonds.

Bonds are loans to private companies or federal, state or local governments with the promise — although not always the guarantee — that the borrower will pay back the principal along with interest by a certain time, called the maturity date or term.

The interest rate is set and is usually paid at regular intervals, such as quarterly, which is why bonds are called "fixed-income securities." However, some types of bonds don't pay the interest until the bond matures.

Generally, the longer the term of the bond, the higher its interest rate. Municipal bonds, on the other hand, offer lower interest rates compared with similar corporate or U.S. Treasury bonds because bondholders don't pay federal tax on the earnings.

"Investors often turn to bonds because they see them as a safer alternative to stocks," Filangeri said. But that's not to say that bonds are without risk.

Bond investors face several types of risk, depending on the type of bond. For example, there is the risk that the issuer will fail to make its interest or principal payments as scheduled — or perhaps never, if it goes bankrupt. That's called credit risk.

The higher a bond issuer's credit risk, the higher the interest the issuer will pay. Bonds issued by companies that have a very high risk of defaulting are called high-yield bonds, sometimes referred to as junk bonds. Even local municipalities and other government bonding agencies carry credit risk. Only the federal government is able to guarantee that it will pay principal and interest on its bonds.

However, that doesn't mean there is no risk in owning U.S. Treasury bonds. Like all types of bonds, Treasury bonds face interest rate risk — the risk that you might lose principal should interest rates rise during the time you hold the bond. Bondholders often get confused about this point. When interest rates rise, the price of a bond falls, and vice versa. Think of it as a seesaw, with interest rates on one end and principal at the other end.

Interest-rate risk is not a risk if you hold a bond until it matures. However, should you want or need to sell the bond before maturity, you could lose money, Filangeri cautioned, even if it's a Treasury bond. Why? Filangeri offers the following illustration: Say you buy a 10-year Treasury bond for $1,000 that pays 4.5 percent interest. Two years later, you decide to sell it, but interest rates have risen to 5.5 percent. No one is going to pay you $1,000 for a bond that pays 4.5 percent when they can buy a bond paying 5.5 percent for $1,000. To compensate, they'll pay less than $1,000. That's how you can lose money even on Treasury bonds.

Closely tied to this seesaw effect is the maturity of the bond. The longer it takes for the bond to reach maturity, the more sensitive it is to interest rate changes. A 1 percent interest rate change will affect the price of a 10-year bond more than a two-year bond.

Another confusing area for bond investors involves individual bonds vs. bond funds. Investors commonly buy bond funds instead of individual issues because they require a smaller investment to get good diversification and professional management.

However, bond funds usually don't have a maturity date. They may invest primarily in bonds with roughly similar maturities, such as short-term or intermediate, but because a fund continually buys and sells, there's no final maturity date. Thus, unlike investing in an individual bond, fund investors face a greater risk of selling at a loss.

Many bond investors also don't recognize another significant risk for bonds: inflation. Because interest payments are fixed, rising inflation, even if it's modest, eats away at the buying power of bond income. (An exception is the relatively new Treasury Inflation-Protection Securities, or TIPS, which adjust for changes in the inflation rate.)

That's why most financial planners recommend that investors, including retirees, hold a mix of stocks and bonds. Bonds provide stability and income when stocks are down, and stocks usually will counter inflation through higher returns over time.

Zall, Bureaucratus columnist and a retired federal employee, is a freelance writer based in Silver Spring, Md. He specializes in taxes, investing, business and government workplace issues. He is a certified internal auditor and a registered investment adviser. He can be reached at milt.zall@verizon.net.